Daily Comment (September 28, 2022)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EDT] | PDF
Our Comment today opens with an update on the Russia-Ukraine war, including new details on how Russia’s new mobilization is playing out. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a focus on the turmoil in the U.K.’s financial markets today, which prompted the Bank of England to launch a new, time-limited program of bond purchases to stabilize the markets but has added to the recent weakness in the pound.
Russia-Ukraine: The Ukrainian military continues to push forward with its counteroffensives in the northeastern region around Kharkiv and in the south around Kherson, while Russian forces try to shore up their new defensive lines even while staging some new attacks in the Donbas region. Meanwhile, it now appears that Russia’s new mobilization order may generate even less combat power than many observers have expected. New reports indicate that the freshly mobilized troops, many of which have no military experience at all, are being sent to the front lines near Kharkiv and Kherson with only one day or less of training. At the same time, Russian authorities are establishing checkpoints at Russia’s borders to forcibly mobilize Russian men who are seeking to avoid deployment by fleeing the country. Russian officials are also setting conditions to forcibly conscript Ukrainian civilians in soon-to-be annexed areas of occupied Ukraine.
- Yesterday, Russian authorities in their occupied areas of Ukraine wrapped up their sham referendums on annexation to Russia and reported overwhelmingly positive results. The move will allow President Putin to announce formal annexation of the areas to Russia as early as Friday. Besides marking a political line in the sand, the move could potentially allow Russia to deploy conscripts to the occupied areas and even extend Russia’s nuclear deterrence over them, based on the argument that the areas will now officially be Russian territory.
- One little-noticed implication of Putin’s new mobilization order is that it will likely further disrupt the Russian economy. Not only will the marshaling require huge sums to equip and pay the new troops, at a time when the Russian budget is being impacted by falling energy revenue, but it will also disrupt many businesses as workers are scooped up by the military or emigrate to avoid military service.
- On the energy front, European officials continue to investigate what caused the three leaks in the Nord Stream 1 and 2 natural gas pipelines from Russia to Western Europe. However, Danish Prime Minister Frederiksen and NATO General Secretary Stoltenberg have both indicated it was sabotage. Since such sabotage would most likely have come from Russia, the incident has touched off a scramble among European countries to secure their energy infrastructure. A key target of those efforts will be the natural gas pipelines from Norway, which have now become one of Western Europe’s most important sources of gas.
United Kingdom: Trying to calm the economic and financial market turmoil touched off by the new government’s massive tax cuts and energy subsidies, the Bank of England today said it would pause its planned sell-off of government bonds and instead purchase longer-dated gilts “on whatever scale is necessary” to restore market order. The move comes just one day after Chancellor Kwarteng said he has been meeting with BOE Governor Baily every day to better coordinate fiscal and monetary policy.
- In the economic and financial market chaos yesterday, the 10-year gilt had sold off to yield 4.51%, and some mortgage companies suspended new fundings. Following the BOE action today, the benchmark gilt yield has now fallen to approximately 4.00%. The action also affected other major government bond markets. For example, the benchmark U.S. Treasury yield had pushed to 4.017% early in the overnight trading session, marking its first foray above 4.000% in over a decade, but it fell back on the BOE news and currently stands at 3.871% as of this writing.
- One particularly disturbing development over the last couple of days has been that many British insurers and pension funds had faced big margin calls on their gilt holdings. Those margin calls further fed the sell-off in government bonds, driving yields higher and threatening to undermine the U.K.’s financial stability.
- Since the government’s massive fiscal stimulus threatens to drive British consumer prices even higher, investors had been looking for the central bank to implement huge interest-rate hikes, bringing their benchmark rate to 6% or more in the coming months. The move to buy bonds now could potentially raise some question about the BOE’s ability to resist government pressure and to keep tightening policy over time.
- Huge interest-rate hikes that rein in inflation could well push the British economy into recession. Alternatively, if the government convinces the BOE to minimize its rate hikes, investors could start to question the central bank’s commitment to price stability. In either case, the implication is continued depreciation of the pound. Indeed, the pound initially rallied on today’s BOE move, but it has since turned lower again and is now down 1.5% for the day to a value of $1.0572.
- Meanwhile, the IMF issued an unusual rebuke of the tax cuts yesterday, saying, “Given elevated inflation pressures in many countries, including the U.K., we do not recommend large and untargeted fiscal packages at this juncture.” In response, supporters of Prime Minister Truss defended the move in part by stressing that the government doesn’t plan to release its spending blueprint until November. Truss has previously said that she wouldn’t cut spending, but the statements from her supporters indicate the government plan may well go against that promise, most likely to target social spending.
Chinese Currency Markets: Although the recent dollar appreciation has led to lower values for a range of major currencies, the pound and some others have weakened more than others. The onshore Chinese yuan so far this morning has fallen to 7.2268 per dollar, marking its lowest level since 2008. The yuan has now lost 13.8% of its value so far in 2022
- In response, the People’s Bank of China issued a statement saying, “The foreign exchange market is of great importance, and maintaining its stability is the top priority.”
- The central bank statement could signal that it intends to intervene in the market in the near future if the currency continues to weaken.
Chinese Politics: Putting to rest the weekend rumors about a coup, President Xi reappeared in public leading a delegation to a major propaganda exhibition. Even though the appearance proved Xi is still in power, and even though we still expect him to secure his precedent-breaking third term in power at the Communist Party’s 20th National Congress next month, the coup rumors do underline that there is probably some opposition to Xi within the party.
Saudi Arabia: Yesterday, King Salman named his son, Crown Prince Mohammed bin Salman, as prime minister, further cementing the crown prince’s power over the Saudi state. The move was probably also meant to help rehabilitate MBS in international politics, given that he has been treated nearly as a pariah due to his role in ordering the death of a dissident journalist in 2018.
Iran: Protests against the government’s strict morality laws and repression of women continue to expand, prompting a further crackdown from the government. The protests and crackdowns so far have resulted in some 40 deaths, hundreds of injuries, and hundreds of arrests. The protests have now become the largest in Iran in years, although the government’s survival does not yet appear to be threatened.
U.S. Monetary Policy: In an online event yesterday, Minneapolis FRB President Kashkari said that the Federal Reserve must avoid repeating its mistakes of the 1970s, when it eased monetary policy too soon and allowed inflation to reaccelerate. Rather, Kashkari warned that the central bank needs to tighten monetary policy until underlying inflation is declining and then hold policy tight until it is sure inflation is coming down. The statement underscores how aggressively the Fed is likely to approach monetary policy in the coming months and quarters, most likely kicking the U.S. economy into recession.
U.S. Fiscal Policy: After jettisoning Senator Joe Manchin’s proposal to ease regulations around new energy investments, last night the Senate voted to advance a stopgap appropriations bill that will avert a partial government shutdown this weekend when the fiscal year ends. The bill now moves to final passage in the Senate and will also need approval in the House, which returns Wednesday, before going to President Biden for his signature.
U.S. Housing Market: Illustrating how rising U.S. interest rates are weighing on the housing market, a report yesterday showed the S&P CoreLogic Case-Shiller National Home Price Index fell a seasonally adjusted 0.2% in July, marking the seasonally adjusted index’s first monthly decline in more than a decade. The report showed home prices were still up an average of 15.8% year-over-year, but the rate of increase has been slowing, which is likely a harbinger of weaker growth in the broad economy in the coming months.
U.S. Weather Damage: Hurricane Ian has intensified rapidly early this morning, and with sustained winds of 155 miles per hour, it is now close to the standard of 157 miles per hour needed for it to be rated a Category 5 storm. Ian is now projected to slam into Florida’s coast around mid-day today and cause intense flooding and other damage. If it strikes Florida as a Category 5 storm, it would be only the fifth such storm to hit the U.S. mainland.